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To Bonus, or Not to Bonus? That is the Question

A commenter on a prominent internet financial site posed this hypothetical (I actually doubt it was that hypothetical, actually):

As a muni trader, my bonus is derived directly from my P/L which is accrued over the quarter and kept in a separate account. It does not go into the firms bottom line and then back out to me. Also, like most traders, I accrue 2% of my gains in a loss provision account in case I have a major write-down in the year. My bonus is 10% of my profit for the year. If I make $50mm for the year my bonus is $5mm

What does my bonus have to do with the MBS trader who's sitting on losses? Did I or did I not show a profit of $40mm to the firm’s bottom line?

I am very happy this was put up for debate, and I also believe this anonymous commenter to be a big firm trader or banker. After all, it honestly does seem that many of the bankers and traders actually do not understand exactly what the issue is over this bonus thing.

The "mythical" muni trader above, assuming he works for Goldman Sachs, would not be entitled to a $5 mm bonus if he made $50 mm for the year. Why not? Because he generated that 10% return off of taxpayer capital, not firm capital. Goldman Sachs would have had the drawdown from hell had they not been rescued from that bad AIG deal. Let's assume that AIG would have negotiated a 40% payout (if I would have been at the helm, I believe this is about where we would have settled for the litigation with an insolvent company that had many more contingent and direct claims probably would have resulted in lower net receipt). That would have been a 7.8 million dollar hole. Combine this with the TARP of $10 billion that Goldman said they didn't need yet had to raise capital to repay (that tells us all we needed to know about whether they needed it or not) and it is clear to see that Goldman was severely undercapitalized.

Now, Mr. Muni trader now would not have had $50 million to trade with if Goldman didn't get bailed out (twice). It really is as simple as that, thus there is no need to speculate whether he deserved his 10%. The issue is 10% of what. He could have been paid 10% of his own capital, but he is relying on a 10% vig of tax payer capital, and that is where the great misunderstanding lies. Even if somehow one could justify getting paid from taxpayer capital in lieu of one's own capital or the firm's capital, that capital would have (or at least should have, as a product of prudent business - if we can call it that) been pegged with a cost of capital that had a very, very high hurdle rate that the trader would have to earn over. In other words, management should say this $50 million cost 14%, thus you will not have positive ROI until you break that 14% mark. A simpler way of looking at this is just that Goldman wouldn't have had the $50 million to allocate to him in the first place, but more along the lines of $1o million. If the broker earned his requisite 10%, he would have made $1 million, not $5 million, and with the 14% hurdle rate, would not have received a bonus at all, and actual would have been negative 4% (clawbacks, anyone?). Of course these are random, nominal figures, and the cost of capital could have been 10%. To be realistic, the cost of capital should have been what Warren Buffet charged Goldman plus the firms own "vig", which sounds like it would have amounted to 14% anyway.

You see, not only has the government totally negated the concept of the "cost of capital" when handing out TARP (hence they got bent over when it was time to get repaid, and I warned several well placed politicos personally before the fact), but Goldman Sachs and the rest of Wall Street (not to pick on GS) fails to take this basic precept of business finance into consideration when paying bonuses as well. This capital neglect is good for banking employees in the short term, but it is literal rape of banking shareholders, for they are getting their capital used without charge.

Anyone who disagrees with this with argument using perspectives such as "well, each department is charged for capital" is free to debate this in the comments section.

After all if firms do charge inter-department, I doubt that charge is very realistic given they are getting taxpayer capital for relatively no charge.